Every morning when I walk my daughter to school I play a little game with her; when we get to the crosswalk in front of the school, I ask her to wave to me from the gate after she crosses the street. Simple, yes? Well, about half the time she forgets as she runs across the crosswalk, through the gate, and into the school playground. Oh well, you can’t win them all. None of us are, after all, perfect. Even daddy is bound to make a mistake now and then, unlike my own father who, was perfect, at least that’s what he told me. He was fond of quoting, “I was only wrong once in my life and that’s when I thought I was wrong.” Well maybe I’ll get there one day, but that day hasn’t come yet as I was brutally reminded the other day when I did something remarkably foolish. Signals came in for two currency pairs through my phone and I dutifully trotted over to my computer looked at the charts. Liking what I saw I entered two trades, and then returned to my nap open (as I have temporarily resumed my habit of staying up for the London session necessitating my needing to make up for lost sleep during the day). Lo and behold when I awoke my Forex account took a nasty hit – both trades went negative. That’s odd I thought – a pair of bad signals back to back like that. Well, the signals were perfectly fine as I discovered shortly thereafter, I had just unwittingly entered them backwards – indeed, I entered a buy position as a sell and a sell position as a buy. And I usually take great care when I open a trade, but, obviously not this time. Okay lesson learned – one cannot be too careful when opening any position that involves one’s own live account. I know I’ve said this before, but the point is important enough to reiterate again and again for the benefit of those new to the Forex trading business as well as more seasoned traders – it’s a risky business or to put it another way, it’s all about managing the risk. And why? Because losses, regardless of cause, are inevitable and part of this business. But having a plan in place and knowing what to do when a trade goes against you is of paramount importance. Again I cannot emphasize this enough: risk management is everything.
I’m would like to demonstrate the impact of incurring losses at different levels of risk and observe the results on a theoretical brokerage account. Let’s suppose you’re going to start trading Forex and you have opened an account with $10,000. How much should you risk per trade? Let’s look at a few scenarios. Let’s suppose that we want to risk 10% per trade and let’s suppose that, for talking purposes, will have a worst-case scenario of seven losses in a row. How does this impact the brokerage account? See the table below.
In this example 10% was used consistently, and after seven bad trades about half of the account is wiped out. So obviously this is not an example of good risk management. Let’s take the same scenario of seven losses in a row, but this time we’ll risk only 5% per trade:
In this scenario, with a consistent risk of five percent per trade, our account has a drawdown slightly over $3000 or roughly 30%. Better, but still not acceptable. Let’s see what happens when we go to 2% risk:
Okay now this is getting better, after seven losses our equity drawdown is only $1300 or roughly 13% of our account. Let me change this ever so slightly in the in the next example. Note the difference with the chart below with the one above:
Did you see what I did here? After the first loss, I drop the risk down to 1%. Now look what happened – drawdown only slightly more than $500 (or a little over 5%). Much much better. I’m sure some are wondering that the profit potential in 1% risk is not as lucrative as risking 2% or 5% or even more. The point is twofold: losses in Forex trading are inevitable, this I guarantee. If you want a better guarantee, take a page out of Clint Eastwood’s book and buy a toaster. The second point is that every trader needs to understand what his risk is before entering a trade. Returning to our $10,000 account example coupled with a 2% risk, if we enter a trade with a lot size of 0.4, we can safely take a 50 pip stop loss because we know that if our trade goes against us in this and our position is stopped out, were going to lose $200. If we want to keep a 50 Pip stop loss on the subsequent trade, we need to drop our lot size down to 0.2. This gives us plenty of wiggle room in case a trade doesn’t pan out, yet is still sufficient in terms of reward to risk ratio. One can take a bigger lot size for the smaller stop loss in this way and still keep within the 2% bracket, say a 0.5 lot size with a 40 Pip stop loss. Traders can take smaller stop losses with larger lots if desired but is better to give your trade some breathing room then to get stopped out too quickly before the trade hits its potential profit.
In the above examples I showed what happened after losing seven trades. Hopefully this would never happen to anyone, at least not in one sitting. For me personally if I enter three bad positions in a row, the rule is I stop trading for the day. I know that if I offer my account to the market the market will gleefully take it from me. It’s my job to make sure that doesn’t happen so my own personal rule is after three bad trades, it’s time to stop trading, turn the computer off do and something pleasurable for the rest of the day. The more trades tomorrow and the next day and the next, but only if there is still capital left in my account.
Just for fun, let’s see what happens if we lose 14 in a row using the last scenario:
By dropping risk from 2% to only 1% in our $10,000 account, we’re only down $1400. Now I hope this would never happen, I just put this here to show how much loss one can absorb when risk is adequately managed. Pretty neat huh? With adequate risk management one can practically eliminate most of the anxiety associated with trading – I know this helps me to no end. Yes trading is great when you have a consistent streak of profitable trades, but always, always, always be prepared for that unexpected day when things don’t quite go your way. And speaking of taking risks, I see that it’s time for me to go pick my daughter up from school (which involves crossing a busy street) in about 10 minutes so I’ll wrap this up with a bit of a teaser; that is, I will share with you why have been staying up for the London session when, if I had any sense, I would go to bed like a normal person and let my Sominex EA do my trading for me. I have been working on the successor to my Ice Cream Sandwich trade which, although I’m really pleased with it, I was constantly nagged by the idea that could it be better and I think I’ve got it. I’m going live with my Ice Cream Sandwich V. 2.0 starting next week so I will see. And if next week is as profitable as my testing has been, I’ll be sharing that strategy with the group. Just another benefit of Sapphire membership with Slick Trade.
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That’s all for today. Have a great week and, as always, thanks for reading.
JC
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